Introduction to Section 856
Section 856 of the Internal Revenue Code outlines the requirements for a corporation to qualify as a Real Estate Investment Trust (REIT). To be eligible, a corporation must meet specific tests related to its income, assets, and shareholders.
The primary purpose of these tests is to ensure that REITs operate primarily in the real estate sector, providing a beneficial tax structure for investors. By meeting these requirements, REITs can avoid double taxation, allowing them to distribute more income to shareholders.
Income Tests for REITs
One of the critical requirements under Section 856 is the income test, which stipulates that at least 75% of a REIT's gross income must come from real estate-related activities. This includes rental income, interest from mortgage financing, and gains from the sale of real property.
Additionally, REITs must derive at least 95% of their gross income from a combination of real estate-related activities and certain types of investment income, such as dividends and interest. Failure to meet these income tests can result in the loss of REIT status and adverse tax consequences.
Asset Tests for REITs
Section 856 also imposes asset tests on REITs, requiring that at least 75% of a REIT's total assets be comprised of real estate assets, cash, and cash equivalents. This includes properties, mortgage loans, and shares in other REITs.
Furthermore, no more than 25% of a REIT's total assets can consist of securities that are not qualifying real estate assets. These asset tests help ensure that REITs maintain a focus on real estate investments and do not stray into unrelated business activities.
Shareholder Requirements for REITs
To qualify as a REIT, a corporation must also meet specific shareholder requirements. These include having at least 100 shareholders, with no more than 50% of the corporation's shares being held by five or fewer individuals.
Additionally, REITs must be taxable as a corporation, with a board of directors or trustees that oversees the management of the trust. These shareholder requirements help maintain the integrity of the REIT structure and prevent undue concentration of ownership.
Consequences of Non-Compliance
Failure to comply with the requirements of Section 856 can result in severe tax consequences for REITs, including the loss of pass-through tax status and the imposition of corporate-level taxation.
To avoid these consequences, REITs must carefully monitor their income, assets, and shareholder composition to ensure ongoing compliance with the requirements of Section 856. This may involve seeking the advice of tax professionals and legal counsel to navigate the complexities of the Internal Revenue Code.
Frequently Asked Questions
What is the primary purpose of Section 856 of the Internal Revenue Code?
The primary purpose of Section 856 is to outline the requirements for a corporation to qualify as a Real Estate Investment Trust (REIT), ensuring that REITs operate primarily in the real estate sector.
What are the income tests that REITs must meet under Section 856?
REITs must derive at least 75% of their gross income from real estate-related activities and at least 95% from a combination of real estate-related activities and certain types of investment income.
What are the asset tests that REITs must meet under Section 856?
REITs must have at least 75% of their total assets comprised of real estate assets, cash, and cash equivalents, with no more than 25% consisting of non-qualifying securities.
What are the shareholder requirements for REITs under Section 856?
REITs must have at least 100 shareholders, with no more than 50% of the corporation's shares being held by five or fewer individuals, and must be taxable as a corporation.
What are the consequences of non-compliance with Section 856?
Failure to comply with Section 856 can result in the loss of pass-through tax status, corporate-level taxation, and other adverse tax consequences.
Why is it essential for REITs to monitor their compliance with Section 856?
REITs must carefully monitor their income, assets, and shareholder composition to ensure ongoing compliance with Section 856 and avoid severe tax consequences.